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Capital Structure

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Question 1.

Define Capital Structure. What is the importance of capital structure?

 Capital structure is the proportion of debt and preference and capacity shares on a firm's balance sheet.

 A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds

 Optimum capital structure is the capital at which the weighted average cost of capital is minimum and thereby maximum value of the firm. The optimum capital structure or combination of debt and equity that heads to the maximum value of the firm.


 There are only two sources of funds used by a firm perpetual riskless debt and ordinary shares.

 There are no corporation taxes

 The dividend payout ratio is 100.that is the total earnings are out as dividend to the shareholders and there are not earnings.

 The total assets are given and do not change. The investment decision are in other words, assumed to be constant

 The total financing remains constant. The firm can change its

degree of leverage (capital structure) either by selling shares and use the proceeds to retire debenture or by raising more debt and reduce the equity capital

 Perpetual life of the firm..

 The operation is not expected to grow.

 Business risk is constant overtime and is assumed to be independence of its capital structure and financial risk.


 There is a viewpoint that strongly supports the close relationship between leverage and value of a firm.

 There is an equity strong body of opinion which believes that financing mix or the combination of debt and equity has no financial structure is irrelevant.

 Capital structure can effect the value of a company by affecting its expected earnings or the cost of capital, or both

 Capital structure decision can influence the value of the firm

Following points shows the importance of capital structure and its planning.

1. To reduce the overall risk of company

when we make capital structure before actual getting money from money supplier, we can do many adjustments for reducing our overall risk. Suppose, we have made capital structure in which we add three sources of fund, one is equity share, and other is debenture and last is pref. shares. Because we know that we have to pay debt at its maturity at any cost and its interest at fixed rate. So, we try to get minimum debt in new business because in new business our rate of return will be less than rate of interest and for getting more loan means taking high risk of return more amount of interest even there is no profit.

But, if our business will be succeeded, at that time, we can increase estimated amount of debt by just changing the value of debt in capital structure (written just for planning) in excel sheet.

2. To do adjustment according to Business Environment

Company also adjusts different sources expected amount according to business environment. Suppose in future, if government of India cuts off his relation with China, from where our company is getting fund, it will definitely tough for us to get more money from China. But proper planning of capital structure of future sources will be helpful for us to enlarge our area for getting money. In finance, it is called maneuverability. It means to create mobility of sources of fund by including maximum alternatives in planned capital structure. Suppose, if RBI increases the interest rate, it means your cost for getting debt will be high, at that time, you can choose any other cheap source of fund.

3. Idea generation of new source of fund

good planning of capital structure will make versatile to finance manager for getting money from new sources

Question 2.

Briefly explain the various factors affecting the capital structure?

A nearly endless list of factors relative to capital structure decisions could be created; however, some of the more important of these factors are discussed here. The consideration affecting the capital structure decisions can be studied in the light of the following:


The flexibility of the capital structure refers to ability of the firm to raise additional capital funds whenever needed to finance profitable and viable investment opportunities. The capital structure should be the one which enables the firm to meet the requirements as the situation changes. To be more clear, flexibility means that capital structure should always have an untapped borrowing powers which can be utilized in condition or situations which may arise any time in future due to uncertainty of capital market, Government policies etc. If the capital market conditions are conducive to the issue of capital, then the preference may be given to issue of capital, rather than issue of debt. Further, if there is still untapped borrowing capacity, then debt instruments may be issued, subject to conditions prevailing in the capital market.

Thus, above listed are the various factors affecting the capital structure decision in line with the business and the associated risk.

Minimization of Risk

A firm's capital structure must be developed with an eye towards risk because it has a direct link with the value. Risk may be factored for two considerations: a) the capital structure must be consistent with the business risk, and b) the capital structure results in a certain level of financial risk. Business risk is the relationship between the firm's sales and its earnings before interest and taxes (EBIT). In general, the greater the firm's use of fixed operating cost, the higher its business risk. The level of business risk must be measured as the higher a firm's business risk, the more cautious the firm must be in establishing its capital structure.



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